A Brighter Outlook for Muni Bonds

Municipal bonds have had a rebirth since getting pummeled earlier this year, and the recent tumult in the financial markets has rekindled interest in an investment class with a tradition of safety.

Late last year, financial analyst Meredith Whitney warned darkly that municipal bonds faced a treacherous future, including widespread defaults. Since Ms. Whitney had correctly predicted that banks faced serious trouble before the financial crisis struck in the fall of 2008, many heeded her words.

ENLARGE

Wesley Bedrosian

Muni bonds sold off and questions about the fiscal fitness of states like California and Illinois rattled investors in this historically low-risk market.

But Ms. Whitney's pronouncements haven't come to pass. Indeed, the $3 trillion muni-bond market has resumed its traditional role as a safe haven, attracting increasing interest from skittish investors.

A closely watched muni-bond exchange-traded fund, the iShares S&P National AMT-free Muni Bond ETF (MUB), illustrates the shifting fortunes of the market. In late October, the fund traded above $106. After Ms. Whitney's dark warnings, the fund fell steadily, bottoming out around $96 in mid-January.

Since then, the fund has crawled back higher. And during the latest chaos of Standard & Poor's downgrade of U.S. sovereign debt and roiling questions about the health of the euro zone, the fund has pushed back above $105.

The advantages of muni bonds are several. For starters, they're exempt from federal income tax, a quality that Treasury bonds don't share. If you buy bonds in the state or city where you live, you can often get additional local tax relief.

Second, muni bonds have a strong track record. Defaults in the market are rare. Earlier this month, Central Falls, R.I., filed for Chapter 9 bankruptcy, putting its muni-bond obligations at risk. In addition, Jefferson County, Ala., is grappling with about $3 billion in bad sewer debt and may have to file for bankruptcy.

Even in extreme situations, muni-bond holders tend to do better than headlines would suggest. In 1994, Orange County, Calif., filed for bankruptcy, but its muni-bond holders were paid. Considering all the chatter about the 1930s these days, there's a strong lesson from that period, too. The state of Arkansas defaulted in 1933, but after much legal haggling, Arkansas raised taxes and repaid its bondholders.

Of course, the rally in muni bonds -- like the gains in the Treasury market -- has pushed yields down to very low levels. High-quality tax-exempt 10-year munis are yielding about 2.25%. A recent California AA-minus rated, 10-year offering yielded 2.66%. By comparison, the 10-year Treasury is yielding 2%.

There are two main ways to invest in muni bonds: You can buy them directly or through a fund. There are benefits and risks to either approach.

The advantage of a direct purchase is that you can hunt for better yields. The disadvantage is that the market is opaque and investors can sometimes not get the best price for a bond. For funds, the advantage is that you tend to get better pricing and solid diversification, but you have less control over the disposition of the assets in the fund.

The most popular muni-bond ETF is the aforementioned iShares S&P National AMT-free Muni Bond ETF, with more than $2 billion in assets. The SPDR Nuveen Barclays Capital Muni Bond ETF (TFI) is the second largest, with about $860 million in assets. There are a wide range of mutual funds and closed-end funds focused on munis, and even funds that focus on big issuers, such as New York and California.

When considering individual muni bonds, it's important to stick with high quality. If the last few years have taught anything, it's that even the seemingly safe can become scary very quickly.

Here is a rundown of the main types of muni bonds:

General obligation bonds: Sometimes called GO bonds, these are sort of like Treasurys. They are backed by the full faith and credit of the issuer. That means the issuer is promising to pay back the bonds by any means necessary. Muni-bond experts like GO bonds because the issuers have the power to tax. In other words, they can almost always get their hands on money to pay off the muni-bond obligations.

Assessment bonds: Now we get more specific. These bonds depend on taxes, such as property taxes, that will fund general improvements of a given area. While these bonds depend on a narrower slice of the tax pie, they are still considered pretty safe since the government's power to tax is the main support for the bond.

Revenue bonds: These are more specific than assessment bonds since they are tied to a specific revenue stream, as opposed to a general taxing authority. For instance, a turnpike generates income from tolls that can fund a revenue bond. Tolls can be raised, but that is sometimes trickier than raising property taxes or local sales taxes.

One final factor when thinking of building a portfolio of individual munis: Duration matters. It is wise to have a mixture of short-, medium- and long-term bonds. Duration diversification can protect you from sharp interest-rate swings. And as we've seen, big swings seem more the norm than not these days.

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